Exploring economic and financial instability within global markets and economies.

Wednesday, January 30, 2013

The Impossible Trinity or The Permanent Floor: Adding Modern Money to Mundell-Fleming

The Impossible Trinity (also known as the Trilemma) is a trilemma in international economics which states that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle was initially derived from the Mundell-Fleming model, also known as the IS-LM-BoP model. Although the model was first outlined by Mundell and Fleming 50 years ago, to this day it continues to play a significant role informing public policy. For this reason it also remains a staple of Ph.D. programs, even those that generally despise Keynesian economics. While many students may accept the model’s conclusions based on its longevity and the professions’ widespread adherence (which may be wise), I was naturally skeptical. What are the model’s assumptions? Will different monetary regimes alter the conclusions? What does it even mean to have “an independent monetary policy”? In search of answers, I sought out one of the original sources.“Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates” by R.A. Mundell was published in The Canadian Journal of Economics and Political Science all the way back in November 1963. At the time the world’s major industrial nations were adhering to the Bretton Woods system, under which the U.S. dollar was convertible to gold and all other countries involved tied their currencies to the U.S. dollar. Recognizing the expansion of global trade taking place, Mundell sought to outline “the theoretical and practical implications of the increased mobility of capital. (p.475)” To simplify the conclusions Mundell begins by assuming “the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. (p.475)” He further assumes “that all securities in the system are perfect substitutes” and therefore the “existing exchange rates are expected to persist indefinitely. (p.475)” The last assumption presently worth noting is that “Monetary policy will be assumed to take the form of open market purchases of securities. (p.476)”While these assumptions may have been valid within the Bretton Woods system, that system was terminated in 1971 by President Nixon unilaterally canceling the direct convertibility of the U.S. dollar to gold. Since then the U.S. and several other major industrial nations have been operating using a fiat currency. Under this new monetary regime, without convertibility, there is little reason to believe that all currencies are even near perfect substitutes or that exchange rates will persist for any defined period of time. Furthermore the end of the Bretton Woods system marked the beginning of inflation targeting as the primary method of monetary policy. Monetary policy was still enacted through open market operations after the regime change, but those operations were now performed to maintain an target interest rate. The more significant difference is that using interest rates as the primary tool for targeting inflation ensured interest rates would be maintained at levels different from those prevailing abroad. This “corridor” system of inflation targeting would last in the U.S. for nearly 40 years before being replaced by a “permanent floor” system in 2008.Breaking with previous tradition, the “permanent floor” system (also known as interest-on-reserves regime) allows central banks to control interest rates separate from engaging in open market operations. Interest rates are now (largely) determined by the interest-on-reserves (IOR) rate, while excess reserves give the central bank freedom to let the monetary base fluctuate more widely. Returning to Mundell’s paper, he begins by analyzing monetary policy under flexible exchange rates:

“Consider the effect of an open market purchase of domestic securities in the context of a flexible exchange rate system. This results in an increase in bank reserves, a multiple expansion of money and credit, and downward pressure on the rate of interest. But the interest rate is prevented from falling by an outflow of capital, which causes a deficit in the balance of payments, and a depreciation of the exchange rate. In turn, the exchange rate depreciation (normally) improves the balance of trade and stimulates, by the multiplier process, income and employment. A new equilibrium is established when income has risen sufficiently to induce the domestic community to hold the increased stock of money created by the banking system. Since interest rates are unaltered this means that income must rise in proportion to the increase in the money supply, the factor of proportionality being the given ratio of income and money (income velocity). (p.477)”

The earlier review of changes to the monetary regime makes it clear that this causal chain is fraught with errors. Starting from the beginning, “an increase in bank reserves” does not cause “a multiple expansion of money and credit” (see here) nor will it lead to “downward pressure on the rate of interest.” If interest rates are unchanged, there should be no outflow of capital and no subsequent depreciation of the exchange rate. The balance of trade therefore remains the same and the “multiplier process” never takes place. In complete contrast to Mundell’s conclusion, monetary policy (effectively QE) has no effect on income or employment under flexible exchange rates.*Switching to monetary policy under fixed exchange rates:

“A central bank purchase of securities creates excess reserves and puts downward pressure on the interest rate. But a fall in the interest rate is prevented by a capital outflow, and this worsens the balance of payments. To prevent the exchange rate from falling the central bank intervenes in the market, selling foreign exchange and buying domestic money. The process continues until the accumulated foreign exchange deficit is equal to the open market purchase and the money supply is restored to its original level. (p. 479)”

As previously stated, the creation of excess reserves no longer affects the interest rate. This prevents the rest of Mundell’s process from taking place, but nonetheless results in the conclusion that monetary policy is ineffective. This fixed exchange rate simulation serves as the basis for the Impossible trinity. Given free capital flows and a fixed exchange rate, the central bank is forced to counteract open market operations with equivalent opposing actions in the foreign exchange market. Since the money supply is ultimately unchanged, the country is said to have relinquished its monetary policy independence. However, under the current monetary policy regime this outcome is drastically altered.Mundell examines the common case of a country trying “to prevent the exchange rate from falling. (p. 479)” Using a “permanent floor” system the central bank can maintain its interest rate policy and a fixed exchange rate, but faces limitations since “the central bank intervenes in the market, selling foreign exchange and buying domestic money. (p. 479)” One limitation arises when the central bank runs out of salable foreign exchange. Another limitation occurs once the central bank drains all excess reserves from the system, forcing it to forgo either its interest rate or exchange rate policy. These limitations suggest the Impossible Trinity will hold in the long run.Now consider the less frequent and more recent case of a country trying to prevent its exchange rate from rising. The central bank manipulates the market exchange rate by buying foreign exchange and selling domestic currency. Contrary to the previous example, the central banks actions suddenly appear unlimited. Since the central bank can always create new reserves, it faces no limitations in selling domestic currency. Meanwhile if the demand to trade foreign exchange for domestic currency dries up, then the central bank will have successfully defended its peg. Therefore, as long as the Fed is willing to accept the risks associated with a balance sheet full of foreign exchange, the Impossible trinity is no longer impossible.The Impossible trinity stems from Mundell and Fleming’s attempt to incorporate an open economy into the IS-LM model. Their analysis reflects an understanding of the Bretton Woods system, which ruled monetary policy at that time. Today’s monetary system and policy operations are a far cry from the Bretton Woods system, yet the Mundell-Fleming model has not been updated accordingly. Beyond minimizing the effects of monetary policy, the transformation of monetary policy to a “permanent floor” system has made the previously impossible, possible.

9 comments:

"While these assumptions may have been valid within the Bretton Woods system..."

There exists a huge misunderstanding in the blogosphere about fixed exchange rates/Bretton Woods etc.

Even Mundell himself seems to have conceded that central banks were operating under a "banking principle" as opposed to a "bullion principle".

The Mundell-Fleming approach or IS/LM/BP doesn't work in any setup.

"Under this new monetary regime, without convertibility,"

Careful again. While official convertibility may have lost its significance, currencies are by no means not convertible. There is market convertibility. I don't know why this point "no convertibility" is repeated often. The usage of the phrase convertibility is also legal.

"In complete contrast to Mundell’s conclusion, monetary policy (effectively QE) has no effect on income or employment under flexible exchange rates.*"

That is a big claim. It is true that fiscal policy is much more powerful but you needn't say that monetary policy has no effect on income and employment. If the central bank raises rates all the way till 20%, it will lead to a catastrophe.

Back to BW, monetary policy was still about an interest rate. In both regimes, monetary policy is part of "demand management". While there was pressure to attract funds from outside in BW, it is by no means true that this is not the case in recent times.

Thank you very much for the comments. My knowledge of the Bretton Woods system is somewhat limited at this point, so I will have to read more on the subject. Do you have any recommendations?

I recognize the Mundell-Fleming model may not be applicable in any sense. However, I thought it might be useful to reconsider it without altering too many assumptions. If it's going to remain influential in policy circles and Ph.D. programs maybe there is a way it can do less harm.

You are certainly correct about the improper use of "no convertibility." I'm so used to hearing the term in reference to fixed exchange rates that I confused the terminology.

Regarding the big claim on monetary policy, I clearly did not make my disclaimer apparent. If you note the asterisk, at the end of the post I said:"*In reality, monetary policy (QE) will affect income and employment to some degree for reasons not outlined by Mundell. However, those effects are likely to be small and could be either positive or negative."

Yes not convertible at a fixed rate but frequently slips and one sees "non-convertible".

You can find the description of BW in Godley/Lavoie's text.

The important thing is that everything finally comes down to balance of payments. In fixed exchange rate regimes one sees spectacular fall of the exchange rate and in floating exchange rates the adjustments are slow.

The adjustment typically happens via incomes in both regimes. It is important to not fantasize too much and think that all nations can truly float their currencies in the international foreign exchange markets without official interventions. Some don't want to and others cannot so easily.

When you mention the balance of payments, is it correct to assume you are including trade of financial assets and not simply imports/exports of goods? If so, how significantly do you think these effects are on exchange rates for developed countries?

Obviously in a case of a country with a depreciating currecy, the amount of FX reserves will be a constraint on the exchange rate level.

In the case of an appreciating currency it is correct that the central bank can expand the monetary base as much as it wants (by buying FX) and sterilize the effects by paying IOR and/or providing fixed-term deposits/CB Bills. Nevertheless, as long as the initial exchange rate pressure is an outcome of relative interest rates, a currency peg might actually reinforce capital inflows. The end result will be a central bank balance sheet with FX assets paying a low interest rate (with a value pegged to the local currency) and local currency liabilities paying a high interest rate. Ultimately, that means that the CB will have to accept losses on its operations and a possibly negative long-run capital position. I think the CB reaction to such a scenario is still an open question.

You bring up a very interesting point about the initial pressure that I hadn't fully considered. The cases I was primarily considering, Japan and Switzerland, are clearly not due to relative interest rates. I suspect the US and EU might find themselves in a similar position where capital inflows are undeterred by zero interest rates. However, a country such as China could eventually present a test case.

As for a negative long-run capital position at the CB, I discussed that topic recently: http://bubblesandbusts.blogspot.com/2013/01/the-permanent-floor-and-potential.html.While I don't think CBs would be prevented from continuing operations, I agree the full effects remain an open question.

I'm still working through all of the potential implications, which I hope to eventually write up in a paper. My initial take is that the cost of holding down the exchange rate, for countries like Japan and Switzerland, is fairly small. This also makes it easier for the strong currency nations to help weaker ones defend fixed exchange rates.

These are some of the issues I'm still trying to sort out:1) How and to what degree do financial asset flows affect currency valuations? Mainstream economics focuses primarily on trade balances and therefore expects floating exchange rates to bring trade into equilibrium. However, the Japanese Yen has consistently appreciated for ~20 years despite persistent trade surpluses and zero interest rates. 2) To what degree, if at all, does the proportion of broad money supply made up by the monetary base alter implications? Once financial assets are considered, outstanding dollar assets are clearly several multiples of the monetary base. Adjustments to the base due to fixed (or dirty float) exchanges rates may therefore have far less impact.

"Now consider the less frequent and more recent case of a country trying to prevent its exchange rate from rising. The central bank manipulates the market exchange rate by buying foreign exchange and selling domestic currency. Contrary to the previous example, the central banks actions suddenly appear unlimited*. Since the central bank can always create new reserves, it faces no limitations in selling domestic currency. Meanwhile if the demand to trade foreign exchange for domestic currency dries up, then the central bank will have successfully defended its peg."

Well, the relevant case is a devaluation: sterilizations of hot money inflows can happen even in a gold standard. The asymmetry between creditors and debtors is known. In fact your example in a two countries model holds true just if A & B (akar rest of the world) always cooperate.

*Yes, but if the scenario isn't a "ZIRP" one is likely to assume foregneirs will demand also more assets and not only money affecting both IS & LM curves. I should think a little bit more about it, but I'm not so sure about the fact Central Bank face no constraints. In general I don't think USA are good test for Mundell-Fleming model: the possibility of being the issuer of the reserve currency of the system isn't assumed in the model.

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